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Unformatted text preview: Chapter 12 Capital Budgeting: Estimating Cash Flows and Analyzing Risk ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 12-1 The firms FCFs reflect both its past and current investments. Past investments produce current FCFs, but current investments are expected to add to FCF at some future point. Conceptually, a projects projected cash flows and are expected to contribute that same amount to the firms future free cash flows. In practice, project cash flows are analyzed to determine what projects the firm will invest in, and then the sum of those investments, and the cash flows they produce, will in the future be reflected in the firms FCFs. If a firm identifies and then invests in positive NPV projects, this will increase the value of its operations as determined by the FCF model. The central issue is analyzing individual projects, and here the key factor is assessing the cash flows. See the BOC spreadsheet model. We go through the model to show how capital budgeting projects are analyzed. In this case, the initial NPV, IRR, and MIRR, all evaluated at the 12% average cost of capital and using the expected input values, indicate that the firm should accept the project. However, the risk analysis as done in the scenario analysis indicates that the project is riskier than average, hence the evaluation should be done with a somewhat higher WACC. Note that firms have two types of assets-assets-in-place (past investments) and growth opportunities. The FCF projections reflect the results of assets now in place and also its expected future investments from growth opportunities. 12-2 Externalities relate to effects that a given project might have on the firms other assets. More broadly, externalities relate to effects within and outside the firm. An internal externality might be a situation where a utility has an old and inefficient plant that is costly to operate and that also produces a lot of air pollution, and if a new plant is built, then the firms costs will be reduced and it will also pollute less and thus have lower external costs. Note, though, that the new plant will take production away from the old plant, and this is called cannibalization . Internal externalities can also be positive. For example, if the firm agrees to build a generating plant that would help alleviate Californias energy shortage, then certain customers might agree to buy power from the firms other units and thus raise their profitability. Note too that if the company were required to deal with the pollution the plant created, this would convert the external cost to an internal cost, and the costs of the pollution mediation would have to be built directly into the cash flow analysis....
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- Spring '09